Sunday, February 18, 2018

Misinterpreted Signals – Weekly Blog # 511


There should be much to learn from the last six weeks that could influence our investments going forward. Unfortunately, these inputs do not lead to a quick sound bite, which isn’t bad.  “Sell in May and Go Away” with a return in November, might help equity traders, but would be of little help for long-term investors who are tasked with paying a long stream of future bills. To aid our diverse audience I have divided my focus into three buckets; equity, debt, and inflation.

Equity Prices

Analysts tend to utilize tools which they are most familiar with. In my case, the main investment vehicle is mutual funds, particularly actively managed funds. Each week, my old firm publishes the average investment performance of 8,452 diversified mutual funds largely invested in the US (USDE). After fourteen straight months of gains I saw that the USDE had a gain of +4.37% for January. By the 15th of February the gain for the first six weeks of 2018 had shrunk to +1.53%.  Disregarding the effect of compounding, if that gain was to continue for calendar year 2018, it would be a gain of +13%. That is still too high relative to its past history of +8.41% for the past three years or +8.12% for the past ten years (through the end of January). These eight percent moves are within the long term range of 9% since 1926 for the S&P 500 Index, so are believable. Contrast that with the 12 months performance of the USDE to the end of January of +21.34% or twelve months through February 15th of +14.73%. Thus, there is room for those who expected a continuation of last year’s growth rate to be disappointed. Near term, some of my market analyst friends would only believe the February recovery if there is a meaningful test of the recent low points.

I have an additional concern that the majority of portfolio managers did not actually experience the 1987 decline and recovery and they won’t be attuned to additional insights from that experience. Almost all of the words written about 1987 are about the failure of so-called “portfolio insurance,” not only to protect institutional portfolios but more importantly the contribution to massive sales of equities and derivatives into a weak market. 

There are two other insights that have value today. The first, as pointed out to me by a client during the onslaught, was that while our domestic economy was shrinking due to the Volcker-administered high interest rates created to break the inflationary spiral, corporate earnings were growing smartly through a combination of exports and foreign subsidiary earnings. I suspect that these trends are even stronger today.

The second missed input was that one of the best and strongest specialists went to the wall (bankrupt) using his last equity and borrowing power to absorb some of the selling. Because of regulatory changes, there is even less capital positioned to absorb selling today. Also, little has been written about  the beginning prices of 1987 being similar to the year ending prices, the market was flat. Thus, the market system actually worked and provided the basis for a long bull market that extended many years.

Hopefully we can look for useful lessons from our immediate past that we can apply to our current and future investment policies.

Credit Concerns

These past few weeks we have seen some reversal of the more than a year long global rush into fixed income funds. Due to global central bank downward pressure on interest rates, investors have been in a scramble to find higher income yields without a great deal of concern for principal risk. It is not yet clear if the sizable redemptions in High Yield funds are a display of concern that the inevitable rise in interest rates will make the refinancing of high yield debt more difficult or the beginning of a concern that some of the debt won’t be paid off as scheduled. At the moment we are not seeing the institutional market reflecting the same reaction to bank loan/floating rate vehicles. However, a number of private equity managers have noted that they are seeing an increase in the use of leverage globally.

It is important to understand the impact of a defaulted loan or delayed interest payments on the financial system. Loans from various financial institutions are treated as earnings assets which produce income to pay bills. If these experience slow or no payments, the expected users will have to change, usually by restricting their ongoing payments. In addition, if the defaulted loan was an earning asset for a financial institution, its capital is involuntarily reduced. Perhaps, the most insidious element of defaults is that they cause rumors to fly within the global financial community and beyond. This causes the institution with the perceived bad loan to quickly restructure its loan and other portfolio elements, magnifying the impact of the rumored or real defaulted loan.  Loans can go into default for lots of reasons, mistakes in judgment as to the extent ion of credit to clients, bad product and pricing decisions, acts of nature, and loss of integrity anywhere along the payment line. Unfortunately, as interest rates rise the pace of activity accelerates, which can lead to an acceleration of the problems listed. More exposed fraud becomes visible as rates rise.

There is a strong connection between a threatened credit community and the equity market. Many equity based financial institutions are vulnerable, including money mangers, brokers, and liquidity providers such as market makers, authorized participants for ETF/ETNs, and credit extenders. Most often they function with borrowed money, usually in the form of call loans (which can be called at anytime without reason). The firm that went to the wall in 1987 and Lehman Brothers could have been saved if instant credit was available to them. I am not aware of such a need today, but the rumor or the reality of such a need can come very quickly anyplace in the world.  As we are so interconnected globally, it is conceivable that on any given morning we will be forced to react to such a happening.


Hardly any investment meeting that I have attended in the last couple of months has not included a discussion on inflation. I believe that these discussions, along with the purported discussions at various central banks and by most pundits, have been focused on easy and incomplete data. The focus has been on prices, including reported wages. Not only does the data not deal with changes in quality, terms of trade, and non-reported wages, it also does not deal with the “informal economy.” 
I am becoming increasingly concerned that the strength of deflationary trends is not fully understood in assessing spending habits of consumers at all levels. One of the major deflationary trends is technology under Moore’s Law. Each year the power of our cell phones and other technology grows. This can be measured easily, but what can’t be is its value in terms of what we can now do that we couldn’t do last year in terms of commerce, enjoyment, and better health.

I suspect that one of the reasons for the declining number of auto deaths is due to the large number of computers in each new car. It has also led I believe, to less time in the repair shop. This is caused by two trends. The first is that the modern repair shop is equipped with its own computer set up to interrogate the car’s system. And second is a trend we see in all of our mechanical devices, of replacing rather than repairing. (How many young repair people do we know?) 

When economists look at wages, they look at it from the workers' take home pay level and exclude payments the employers are making to benefit the worker in terms of social security taxes, health insurance and retirement contributions, all of which have been growing faster than take home pay. I wonder whether the increase in quality of what we are wearing is included. We are no longer wearing cheap, poorly made imports. Walmart and other supply systems are selling much better quality, which is often delivered by Amazon. In the competitive era that we have been going through, the terms of trade are often more important than price e.g., delivery time and conditions, payment schedules, advertising support, etc.

For the above reasons I have little confidence in the value of the published inflation numbers and hope that the Fed and the other central banks will be slow in reacting to reported trends. The consumer and commercial worlds are much better at adjusting to change in conditions than people sitting in capital cities.


We are in a new era of more rapid changes. Dividing one’s portfolio by various timespans can minimize the risks to your total capital.

Question of the Week;

Have you materially changed your 2018 portfolio?      
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Tuesday, February 13, 2018

Stocks Are Not Concerns of Contrarians; Structure & Debt Are - Weekly Blog # 510.


I attempt to learn every single day. Further, as a disciple of betting on racehorses, I am always searching for the potentially successful contrarian bet. Contrarians perceive potential future developments different than the crowd. Thus, they almost always are premature and often wrong. However, since contrarians by definition have fewer followers when they are wrong (or too premature) losses are relatively small.

Normal Stock Markets Decline

Anyone that has studied the laws of gravity or were a ground-crunching US Marine, is used to a long march up a hill or a stock chart followed an accelerating decline. We should have expected it because of the length of the past performance streak.

For the last ten years earnings growth has been declining and most of the time operating earnings have been growing in the mid-single digit range. On the other hand, due to the central banks/governments’ manipulation of interest rates, risk assets mainly stocks, attracted inflows. Using the average US Diversified Equity Mutual Fund  investment performance for periods ending at the end of January produced the following results:

Average US Diversified Equity Fund Performance

Period Length
% Total Reinvested Return
One Year
Two Year 
+ 20.96%
Three Year
+ 11.12%
Five Year
+ 12.53%
Ten Year
+   8.12%

Any follower of statistical streaks, e.g., Super Bowl winners, election victories, or rainy days would doubt the continuation of a streak. Despite the Atlanta Fed’s latest forecast of GDP 2018 growth of 5.4%, streaks end  often to the disbelief of the crowd.

First Contrarian Concern

The stock market structure  has changed and some very successful people are betting on further changes.

A strategist at JP Morgan* has noted that there has been massive redemptions by commodity trading advisors and risk parity pools. Charles Schwab* has noted massive unwinding of “short vol” and other positions to meet margin calls. In the latest week, according to my old firm, conventional equity mutual funds had net redemptions of $3.1 Billion and equity ETFs had net redemptions of $ 20.8 Billion. While there may be some double counting in these observations, what is clear to me is that the trading community reacted much more and faster than the longer-term investment community. (We can discuss privately whether we are seeing modern day Sir Issac Newtons at work.)

From a longer term point of view I am much more concerned in watching three of our most prominent investment leaders adding dramatically new (to them) investment activities. Goldman Sachs* going into consumer small loan business through Marcus. Black Rock announcing that it wishes to raise $10 Billion to permanently invest in long-term minority positions similar to Warren Buffett and Charlie Munger at Berkshire Hathaway* and some of their other holdings. Blackstone becoming the 55% partner in ThomsonReuters* financial services, currently managed by Reuters.

*Owned in a private financial services fund or in personal accounts

Each of these may make sense, but requires the use of talents that they may not have already.

What is much more significant to me as a stock market investor is that they are saying that their existing businesses are insufficient to produce enough of the expected profits.  When a crowd moves to a different casino table or shrinks around a trading post on the floor of a stock exchange, one has to wonder whether these bright people are saying something very fundamental to which we should be paying attention.

Second Contrarian Concern

One of the reasons for the victory in the last Super Bowl was the winner had better defenses than the loser. When Marines are forced to go into a defensive position they continue to examine it for possible weaknesses. Most defenses are based on an orderly collection of principles. The two main fixed income considerations are duration/maturity and credit quality. 

Around the world the search for somewhat acceptable yield has led to record sales of bond funds and other credit bearing devices. Due to low and until very recently declining yields, investors have been lengthening their duration to get higher yields even though central banks/ governments are raising rates. The traditional ethos of investing in fixed income is that one makes money through receiving interest payments and hopefully reinvesting them wisely if they are not consumed. Most of the time investors are not concerned about losing principal as the bonds promise to pay off at par. Great theory, but when rates change and fixed income prices decline, bond fund net asset values decline. This is what has opened in the year 2018 up to February 8th. The average Core Bond fund on a total return basis declined-1.67%. This is the largest category for retail investors. Even more disheartening was the performance of the general US Government funds -3.83%. This demonstrates when rates move up a small amount investors can lose money. One needs to remember that there have been periods when high quality rates reached into the double digit range.

My real concern is the possibility of some credit instruments not paying off in full or on time. As someone that sits on investment committees that are besieged by the newest and latest credit instrument vehicles, my guess is that many will be okay, but some may not. For example, a credit fund for a management group that has had prior trouble announces its week even; with 40% in cash they have felt it needed to reduce its net asset valuation in half. Many of the new credit vehicles in the US and other markets  are staffed by bright people who believe in the numbers provided and their derived algorithms. As interest rates move higher, integrity throughout the system may not.

While one can certainly lose more money in stocks than fixed income securities, the expectations are different. In fixed, one expects most of the time is disappointment with the smallness of the gains. Most investors do not expect to have any loses in fixed income. At this point in the cycle, one should be aware that there can be losses and on an emotional basis of disappointment there can be more risk in fixed income than in recognizable volatile equities.

Question of the Week: What are you watching for in terms of fixed income risk?  
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Sunday, February 4, 2018

Friday and Super Bowl Investment Lessons - Weekly Blog #509


Sound investment thinking should not be isolated into an island of investment and economic numbers. The powerful future trends are not found initially there. The future is determined by people and how they think and occasionally react to what they feel about what they think they see. On this Sunday we are between Friday’s worst stock market decline since 2016 and the most significant Professional Football championship. Both or neither could be guides to the 2018 investment future.

Friday’s Stock Markets Actions

Depending on your personal favorite stock price measure, there was a low to middle digit percent decline was the beating headline. Far too many saw the fall as an automatic signal of potentially a much bigger slump. As usual, too many did not look further into it to see the significance. To me, they missed three important inputs staring with the smallest and moving through to more major structural issues.

Warehouses Provide Pricey Liquidity

Early in my investment career at a famous trust bank, I came across some large cap stocks that were unlikely to be price performers that were in numerous otherwise reasonably sound portfolios. The conservative investment still carrying the burden of the learned Depression experience were afraid in the 1960s that the then economic expansion would end with a substantial stock market decline. They had learned the risks of premature market timing and opted to put a portion of their client’s trust money in stocks that would rise in some symphony with an expanding economy, but would fall less than the market when the turn came.  The classic warehouse stock was AT&T which had not changed its common stock dividend since 1922. In effect it became a bond substitute and rose when yields declined and grudgingly held most of their value when interest rates rose in a contraction. (The current AT&T is not the same company and today may or may not be attractive due to its relatively high yield and the prospective benefit of the forthcoming 5th generation of the internet.) The owners of warehouse stocks were not criticized when they cashed in these stocks and used the cash to cushion the portfolio decline and eventually use the cash to buy more aggressive stocks at cheaper prices.

What appears to have happened Friday was several handfuls of large cap stocks fell more than the general market excluding these stocks. Many of these stocks were dominant holdings in Large Cap Growth mutual funds and similar ETFs. Numerous Mid and Small Caps fell much less. Is that due to the fact that they did not have a “warehouse function” on the way up or that their owners recognized that the trading capital in the market was unlikely to support significant sudden liquidation of the smaller brethren?

What I takeaway from Friday’s market action is a concern that there is not sufficient liquidity in today’s market to absorb easily a broad scale sell off.

Liz Ann Sonders/Minsky Moments Explanations

Liz Ann Sonders, Charles Schwab leading market analyst points out that there is a history of years with low stock price volatility and are followed by higher ones. As one of the better analysts on market sentiment and its limits, she points out that in the last three weeks in January the S&P500 went up over 7.5% and if annualized would have added 155% for the year.

Her caution parallels an earlier worry of the great Austrian economist who noted that periods of economic stability end with periods of instability.

Bottom line: too much complacency can be dangerous to your wealth.

Supply/Demand Better Analysis

All to often we make financial decisions based on numerical comparisons. Yet what we call judgment in many cases are human memories that our brains carry. For example, we tend to measure corporate success in terms of dollar revenues. Many automobile manufacturers are showing record dollar revenues, but in terms of units sold or even more important, number of customers/ families served, the results are more discouraging. The shift from two door sedans to five door SUV models hides these trends. The current enthusiasm for stocks is based importantly on better profit margins as taxes and burdens of excessive regulation are enlarging profitability. Most of the countries in the developed world have reached peak population except for immigration. In the US we have one birth every eight seconds, one death every ten seconds. Including migration, we are adding one person every eighteen seconds. Global population  is adding 4.3 births per second with deaths 1.8 per second which translates to 2.5 persons per second. This suggests that the US population’s future economic growth is more likely to come from serving and being served by people in the Southern Hemisphere with particular focus on Africa and Southeast Asia.

While I can direct our clients investment policies to these geographical   centers, until our society does we need to understand our loss of economic and financial ranking. What may make this task even more difficult for their own needs, government and central banks are attempting to manage inflation. They have not been particularly successful. Apparently inflation is actually a derivative driven by currency and trade. These in turn are propelled by a combination of consumers and commercial interests.

Hopefully Friday’s action suggests to all of us that we are living in a changing world where the future is not going to be copied from our old experiences.

Boston-Philadelphia Super Bowl Investment Lessons

Perhaps it is particularly instructive to search for investment lessons from a championship that puts football teams from these two cities against each other. While these two are no longer the largest or politically the most powerful cities in this country, they have contributed greatly to the formation of the US global financial community. Boston due in part to being the home port for the ships that spent years trading with Asia developed a culture of trusted capital management. Even today much of federal and other states’ law that directs much of the fiduciary principles that supervise the asset management industry. At one point there was more money managed by Boston law firms than the mutual fund business.

Philadelphia was not only the home of the Congress at the beginnings of the United States it also developed the key to capital equipment financing. Philadelphia lawyers created railroad equipment (boxcars) leasing certificates which created a global market for transportable assets and in turn supported the global market for mortgages.

For twenty years until I resigned, I advised on the management of the defined contribution plans for the National Football League and the NFL Players Association. From this experience, I believed that on any given day any team within the NFL could beat any other team. Thus as of this  Sunday afternoon I do not know which of these good teams will win. What I do know that the winner on a net basis will have the best combination of offense, defense, capitalizing on surprises, and leadership throughout their organization. These are the very same characteristics that I look for in selecting fund management organizations for our clients. Other inputs for us today are an assessment as to consumer acceptance and politics as seen through the eyes of the media which will color some of our investment thinking as well.

In Conclusion

I hope that we can draw appropriate conclusions from both Friday’s price actions as well as the Super Bowl; thus to be able to manage wisely the year ahead which is likely to be more difficult than 2017.
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Copyright ©  2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.